Description

Company Background:

SIG (Signet Jewelers) is one of the largest specialty jewelry retailer in the world with dominant market shares in the US, Canada, and the UK. It has three of the four largest specialty jewelry store brands in the US, with Kay (#1), Zale (#3) and Jared (#4) and the two largest specialty jewelry stores in the UK, with H. Samuel (#1) and Ernest Jones (#2) as well as the largest specialty jeweler in Canada with Peoples (#1). It operates nearly >2,500 stores in the North America (mostly US, ~200 stores in Canada), and 300 stores Internationally, predominantly the UK.

The company reports across three segments – North America, International, and Other – although North America at >90% sales mix is what really matters.

They also give detail around category mix, with Bridal and Fashion the majority of sales.

This was a business struggling to comp from 2017 until COVID, as they had a lot of issues including poor management and high mall-based exposure. Since then, it has made has made a lot of progress since then with new mgmt. team in 2018. From their FY23 investor day –

Shut down a ton of stores especially with mall exposure (which they continue to do), and focus on productivity

Focused more on the e-commerce channel including the purchase of Diamond Direct and Blue Nile, which is the largest online jeweler.

And have initiated cost savings programs of $700m+ since transformation strategy began.

And rather surprisingly, SIG has pretty dominant share in the large mid-tier US jewelry and watch market (>$90bn). SIG currently has ~LDD% share from ~6% pre-COVID (not all organic), and the industry is highly fragmented with only a few specialty competitors at ~1% share and you can probably put Pandora in there as well.

With that said, the company was a clear COVID beneficiary/over-earner, and there still remains a level of uncertainty in terms of when the category bottoms out in conjunction with the impact of a weaker consumer, as well as how much margin improvement is more structural in nature.

Category:

• Overall jewelry category (based on PCE data) grew at 24% CAGR from 2019-2021 compared to its pre-pandemic (2016-2019) CAGR of 1.5%. Management believes that the jewelry industry will be down worse than ~MSD this year driven by the impacts of macroeconomic factors on consumer spending and continued shift of consumer discretionary spend
• However, the Company’s guidance range of sales -HSD with negative comps also contemplates annual market share gains from ~6% pre-COVID to LDD% (ie from mom and pop stores)
• Last quarter stated the lower end consumer has stabilized
• There was also a massive pull forward in marriages in 2021 (their FY22) after COVID delays that they are still lapping with engagements ~35% of SIG revenue
• The company expects headwinds to continue in engagements with a recovery later in FY24 and continue to rebound in Fiscal 2025 (I don’t think the they’re talking to a 2H hockey stick per-se)

While margins went from MSD, to LDD, and are now guided to the HSD range with EPS down high-teens yoy.

I think the key debates boil down to:

(1) How long will the jewelry hangover last with the potential for a further slowing consumer and macro?

(2) When do engagements resume and provide a tailwind to the bridal segment?

(3) How much were they over-earning post-COVID vs under-earning pre-COVID?

(4) What is the quality of this business? And does SIG have sustainable competitive advantages such as digital and omni-channel capabilities and lab-grown diamonds?

Bull vs Bear:

1. Bull Points:

• A structurally improved business that has navigated choppy retail environment better
• Revenues –
• Hard to call the end to the Jewelry hangover and macro impacts, however:
• Market share gains help offset this hangover and benefit them when it’s over; their goal is reaching 12% over several years
• Lower end consumer has stabilized and SIG could be a beneficiary of trade-down
• Engagement trends are set to inflect and drive material growth in the coming years
• Contribution of higher quality sales, e-commerce mix, and incremental services
• Online capabilities a large positive with Diamonds Direct & Blue Nile adding to James Allen
• EBIT Margins sustaining HSD levels –
• Current levels sustainable and were underearning pre-COVID
• Closing underperforming doors (closed 700+ past 3-years), and focusing more on digital capabilities has significantly increased store productivity now at a 7-year high
• Expansion of margin accretive Services capacity this quarter, advancing our commitment to the jewelry craft, B2B capabilities, and bringing more repairs in house
• Company expects the Blue Nile acquisition to be accretive through both revenue and cost synergies no later than Q4 of next year (lab grown diamonds a strong positive)
• The business was simply spending too much before
• Increased store productivity, combined with most recent $225-250m cost savings program
• Tuck-in acquisitions should help drive top line and share gains over the next several years
• Core inventory is healthy at 20% below pre-pandemic levels
• Capital allocation with share repo and upside from convertible debt repurchase
• $700m+ share buyback left, which theoretically can repurchase ~20% of shares
• Upcoming convertible preferred share redemption adds catalyst for EPS accretion
• Valuation is incredibly cheap at MTHSD EPS

2. Bear Points:

• Despite some changes in the right direction, this is still a low-quality business with low-quality customers
• Revenues –
• Material slowdown in trends is taking place today as consumer dollars are shifting away from jewelry following a meaningful inflection in the category post-pandemic
• Negative hard good read-throughs from higher-end luxury companies
• SIG higher-end customers under pressure and fear of aspirational customers leaving
• Low-end demographic with material credit exposure create potential hard landing if the macro continues to worsen from here
• Customer loss/slippage from store closures
• Low visibility into potential engagement inflection with engagements down 10% or more last year and this year; engagements need to grow ~25% from here just to reach “prior engagement levels”
• Margins are still at multi-year highs and likely still over-earning –
• EBIT margins could revert to the mean back to ~MSD (200+ bps)
• Potential de-leveraging if sales don’t inflect as comps remain pressured plus continued store closures
• How much pressure are merchandise margins under vs 2019, despite management claiming flattish
• Potential headwinds from raw material costs and mix impacts of lower ATV
• Having to ramp spending such as advertising to engage with customers and drive sales
• Increased competition from other jewelers and larger players in the US such as Pandora
• Capital allocation
• Shift from organic to non-organic share gains creates much more operational risk going forward
• Valuation isn’t that cheap if –
• (1) Believe in continued sales/EBIT/EPS resets and declines
• (2) Unwilling to ascribe a higher multiple give perception this is still a low-quality business
• (3) Don’t think SIG has any real competitive advantages or moats

Thesis:

I personally like SIG at such a cheap valuation and on a compelling multi-year view. I tend to agree with the bull camp that (1) new management has done a good job turning the business around, (2) they were under-earning pre-COVID and HSD operating margin levels are sustainable (ie holding guidance despite nasty negative comps and jewelry businesses do tend to have LDD margins), (3) we’re likely hitting the trough this quarter and should see and inflection into 4Q24/FY25, (4) cash flow and capital allocation presents upside opportunity, and (5) valuation is very cheap and could re-rate higher.

Longer-term, at the FY23 investor presentation management laid out some pretty hefty goals for their next 3-5 years, which both I and the street are below at the moment…it continues to remain a show me story IMO.

As it relates to engagements, I think this is more art than science. The Company continues to expect headwinds in engagements with recovery beginning later in FY24 and further rebound over the next three years.

And I’m also bullish on cash flow (at peak were doing >$1bn) and capital allocation, whether it be $700m+ repo, which theoretically can repurchase ~20% of shares or further tuck-in M&A. But the real “ultimate” bull case is the redemption of convertible preferred shares, which could be mid-teens accretive to EPS, and Wells Fargo laid out a $12 x 12x scenario for FY25. A little aggressive, but a redemption could be a significant catalyst for next year.

In 2016 SIG issued $625k convertible preferred shares to Leonard Green for $625m that pay a 5% annual dividend. Currently, the shares are trading below the conversion price at $81, so at the moment there isn’t risk of conversion into ~8m of common shares, although SIG already includes the preferred shares in its diluted share count. Filings indicate the earliest redemption is November 2024, but there is speculation that management may try to buy them out earlier, perhaps as soon as this CY.

Below is Wells Fargos math on the potential accretion of such a deal, which is not baked into mine or street numbers.

I’m not counting on this, but it’s a major potential catalyst that could send the stock much to >$150. I think regardless, the stock is cheap with a strong FCF yield and can work from here, but this would be quite a kicker.

Valuation:

SIG has historically traded in the mid-to-high teens EPS range, and recently has come down to trade ~7x with a teens FCF yield. I’m above the street ($11.47 EPS in F25 vs. St at $10.65), but well below management’s targets. Conservatively using 10x p/e you get to $115 (+20%) and using historical multiple of 15x+ you get to >$172 (+80%).

Catalyst

Earnings